Feb 14, 2014
The word “competition” has taken on a whole new meaning for American business. For one, there’s more of it. For another, it’s far more fierce. And finally, to win requires a lot more than just delivering a great product or service at a great price.
As if that wasn’t hard enough. Winning today requires a distinct competitive advantage.
Today’s senior executives must maintain a 360-degree view of business. They must become experts in areas never dreamt of in an ever-expanding job description. Any misstep can alter that course, and it is a long walk back to get on track.
The good news: Every decision made can lead to a competitive advantage.
Nine times out of ten it is the people that make the difference. And, although it may not be politically correct to say in some circles, it is your key executives and managers that are the key to victory. Not that everyone in the workforce isn’t important, but some are unquestionably more important than others.
ATTRACT AND RETAIN THE BEST
In order to attract, retain and reward key executives and managers, the Fortune 500 have, for years, provided a benefit that allows highly compensated individuals to accumulate wealth on a tax-deferred basis. These plans, also referred to as deferred compensation plans, when designed properly offer a win-win-win scenario for companies, shareholders and participants. These plans are now available to companies of all sizes.
Deferred compensation plans are “nonqualified” plans, (NQDC) meaning that they are not subject to the ERISA (Employee Retirement Income Security Act) and IRS (Internal Revenue Service) regulations governing qualified plans, such as 401(k) plans. Because of their nonqualified status, deferred compensation plans offer advantages that cannot be overstated and should not be overlooked.
- Selectivity – NQDC plans allow you to discriminate. What the plan provides to one, need not be offered to another.
- Discretionary – Companies may decide to make contributions to the plan, or they may not. Contributions one year and not the next. Impose vesting schedules to create “golden handcuffs” or “non-compete cuffs” or offer immediate vesting to create a powerful recruiting tool.
- Flexibility – Companies can structure deferred compensation to meet their individual situation and objectives.
- Costs – The cost of providing a deferred compensation plan benefit, depending on how you choose to structure it, is extremely low by any standard. No other executive benefit costs so little yet provides so much.
You can design and implement a NQDC plan from start to finish in less than a month if you’re quick; two to three months, if you’re not. A lot depends on the plan design and what funding vehicle you use.
KEEP IT SIMPLE
The most successful deferred compensation plans all share one important characteristic: Simplicity. Plans that are easy to understand and interact with receive higher levels of participation, and don’t add to the burdens already placed on internal human resources and finance departments.
The most successful plans are developed by specialists in the field who know how to uncomplicate the process. For example, our firm, Benefit Funding Group, specializes in NQDC plans, and brings many resources to your table:
- Experts in plan design
- Accounting administration
- Simple funding alternatives
- Communication and implementation tools
A dedicated team leads you through the process of designing your plan, taking the responsibility for all the legwork so that your internal resources are not overly taxed implementing the plan. The team interfaces with your human resource team, finance and payroll function, along with any external advisors or counsel.
Before beginning the design process, you need to understand how deferred compensation plans work and how to use them to achieve your company’s objectives. That’s why we created a guide to understanding nonqualified plans and plan design, funding, security, and administration: Designing Nonqualified Deferred Compensation Plans to Competitive Advantage.
THREE PARTICIPANT DECISIONS
In a deferred compensation plan, participants are given the opportunity to defer a portion of their compensation in order to save and invest on a tax-deferred basis, much as they are in a qualified plan such as the 401(k). The amounts deferred simply stay in the company’s coffers until needed to satisfy scheduled disbursements. We will discuss later what the company does with those deferrals from a funding standpoint. The three decisions:
- How much to defer;
- Which investment option to tie returns to;
- When to receive payouts from the plan.
Most deferred compensation plans introduced today allow participants to defer up to 80 percent of salary and up to 100 percent of bonus compensation. The 80 percent salary cap allows for any payroll deductions like FICA and other benefits.
DEFERRAL OF 80% SALARY AND 100% BONUS COMPENSATION
Which investment benchmark options will you offer to plan participants? Most deferred compensation plans offered today allow participants to choose from a variety of benchmark investment options. Others offer only a fixed crediting rate, which is not as prevalent today. In addition, some plans mirror the options found in the company’s 401(k), while others provide a completely new menu of funds.
A lot of this variation is driven by the broker or consultant establishing the plan, and based on their funding recommendations. If the broker is selling corporate owned life insurance (COLI) he or she may suggest you use a different menu, as they can’t match your 401(k) exactly. You should not let the funding decision drive your objectives for fund selection.
If you are looking for simplify, weather matching the 401(k) or a separate menu you should consider using mutual funds and exchange traded funds (ETF) as the overall cost is less. COLI should be considered as an asset only if you have large deferrals that continue to grow and the benefits are long term (i.e. people deferring until retirement which is several years out.
PROS AND CONS OF MATCHING 401(K) MENU
When will the participant take money out of the plan? Years ago it was not uncommon to see deferred compensation plans that allowed participants to withdraw their funds only at retirement or close to retirement, such as age 62. Today, however, most plans being designed allows participants to schedule withdrawals while still employed by the company sponsoring the plan.
Before you start considering what your plan should allow, there are a couple of rules that apply:
- Participants must schedule their withdrawals at the time they elect to defer.
- Withdrawals should be at least two years after the election to defer was made.
- If participants want to re-defer, it has to be at least five from the date of the original election (409A requirement). For example, original election 2018 must re-defer to at least 2023.
Another issue to consider is whether to allow withdrawals to be received in installments or whether amounts can only be paid as a lump sum.
Hardship withdrawals are permitted without penalty (must follow 409A guidelines) and, naturally, if a participant were to die while in the plan their beneficiary receives the entire account balance.
So what should your plan allow? Withdrawals while still employed or will participants have to wait until retirement? Or of course, should you set the rule somewhere in between? The arguments pro and con follow:
SHOULD THE PLAN BE INFORMALLY FUNDED?
When you informally fund a NQDC plan you take some or all the amounts deferred by participants and set them aside for the express purpose of paying the plan’s future liabilities.
Participants like to hear that you actually took their deferrals and set them aside to pay their benefits in the future. Plan participation goes up tremendously when companies informally fund their plans.
Also, most companies that informally fund their plans use a Rabbi Trust, a vehicle that protects participants from the company’s choosing not to honor the terms of the plan, as could occur were there a change in control or ownership. The use of a Rabbi Trust essentially means that participants will receive their distributions in all cases, but the company’s insolvency, in which case the assets of the trust are subjected to the claims of creditors.
HOW SHOULD THE PLAN BE INFORMALLY FUNDED?
Assuming you have chosen to informally fund the plan, you now must decide how the plan will be informally funded. In general, companies that do informally fund their plans invest those monies in either mutual funds or corporate owned life insurance (COLI) policies owned by the corporation, some companies also use their company stock.
According to the 2011 Mullin/TBG Executive Benefits Study “companies continue to favor mutual funds (52.6%) and COLI (42.1%) to informally fund their NQDCPs. Used by 48.8% of respondents in 2010, mutual funds experiences a significant jump in prevalence. COLI usage rose slightly – 41.3% of respondents selected it in 2010.”
In truth, companies are now using multiple assets to fund their plans. The following chart summarizes advantages and disadvantages of the three most popular funding options:
IMPLEMENTING THE PLAN
Finding an independent and knowledgeable consultant is key to success. Bundled providers that have a turnkey solution may prove to be more expensive and less flexible. When you use some of the boutique firms who offer nonqualified plan design, funding and administration, you will find their revenue model is supported by the sale of COLI products. COLI is a good funding asset for long term deferrals, however, funding the entire plan with that asset may not make good sense.
An independent advisor can help with the process. We recommend the following steps and resources.
- Finalize plan design using the consultant and outside legal counsel. The consultant should be able to provide a specimen document that is 409A compliant to minimize your cost.
- Create a work plan to layout events. Again, your consultant should be able to provide this plan.
- Use a Registered Investment Advisor (RIA) with the consultant to select the fund menu and determine the informal funding model.
- Select the enrollment and administrative platform. Here you should look to lower company cost and provide a seamless experience by reviewing current providers such as your 401(k) provider or payroll-company. No longer is there a competitive advantage with boutique providers. In fact, these types of firms could be more expensive, based on how you funded.
- The consultant can assist you with administration selection and help you coordinate key activities with payroll.
- Enrollment today is mostly provided online; the consultant and administrator should have several options for you that work in concert with the plan.
- It is essential to provide reporting to accounting for the liability and the assets held. The administrator should provide daily feeds to accounting, and to the trustee (assuming you are using a Rabbi Trust) or the RIA can provide asset values.
- Finally, the consultant can be a resource to the committee for communication updates.
A nonqualified plan is a valuable tool to attract and retain key employees. Know that it doesn’t have to be a financial or resource burden on the company. With the various types of providers available, many of which you are already working with, combined with the knowledge of the right independent advisor, you can design, fund and administer a plan to create a cost-effective, competitive advantage in the intense market for top talent.
See you on the upside, Bill